A World Awash in Capital

Lawrence H. Summers

Shifts in the global supply and demand for capital are depressing interest rates over the long term, with momentous implications for investors and borrowers, argues Lawrence H. Summer, former Treasury Secretary under President Clinton and former president of Harvard University.

For many years, it has been the conventional wisdom among managers of pension funds, foundation endowments, and other large investment portfolios that it is prudent to operate on a payout ratio of 5%. That wisdom was predicated on the assumption that funds could earn at least 5% annually on a long-term basis after accounting for year-to-year fluctuations in performance. But Summers contends that the payout ratio should be “somewhere under 3%.”

“Payout ratios should be far less, or expected return assumptions should be far lower, than has been the case historically,” he said at a conference sponsored by the National Bureau of Economic Research, “New Developments in Long-Term Asset Management.”

If global finance is in fact experiencing a capital glut, it is excellent news for the United States government, which is the world’s largest debtor. Interest payments on the $21 trillion national debt are a huge driver of budget deficits, and an increase in interest rates could prove calamitous. If Summers is correct, my Boomergeddon scenario could take considerably longer materialize than I suggested in my recent post, “Moody’s Reaffirms AAA Rating. Don’t Get Cocky, Virginia.”

On the other hand, if Summers is correct, chronic low interest rates could depress returns for the Virginia Retirement System and universities like the University of Virginia. The VRS assumes that its assets will average returns of 7% annually over the long term.

Summers argues that the global economy is undergoing a “de-massification” in which technology substitutes for capital-intensive in investment in equipment and real estate. The trend, which is driven by the declining cost of computing power and the rise of Artificial Intelligence, means that businesses need to invest less capital to achieve economic growth. Thus, law firms have shrunk the office space per attorney from 1,200 square feet to 600. And Apple, the world’s most valuable company, decided recently to funnel $100 billion into dividends and share buybacks instead of investing in new capital projects. “Something very important and structural is happening,” he said, when a global innovation leader is deploying its capital that way.

The average yield on U.S. 10-year Treasury bonds and comparable debt for Japan and European nations arguably has shrunk by 250 to 350 basis points (2.5 to 3.5 percentage points) over the past 10 to 15 years, Summers said. In addition to de-massification, he suggested, slower rates of population growth around the world are dampening economic growth and reducing the demand for investment capital.

Writing in my book, “Boomergeddon,” eight years ago, I argued that aging populations, the draw-downs of pension funds, and the rising cost of government entitlements would lead to higher interest rates over the next two or three decades. I failed to consider that de-massification, slower population growth, and slower economic growth would simultaneously depress the global demand for capital.

I’m open to the possibility that an interest rate-led meltdown of U.S. government finances is less likely in a world awash in capital. Let’s just hope that the politicians never get the message, though: Otherwise, they are likely to ramp up deficit spending and the national debt higher than ever. Meanwhile, state governments, elite universities, insurance companies and people saving for their retirement need to adjust to the reality of lower returns on their investment portfolios.

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9 responses to “A World Awash in Capital

  1. This is mind blowing. It upsets most recent conventional thinking. It does so in many different ways while it also sprinkles an array of new drivers into the traditional mix of how our society and its institutions function. And how they grow.

    For example, if Summers is correct as to his predicted end result and also as to the drivers that he sees behind that result, then it is likely that these new forces, and their novel combinations, will reshape how our towns, cities, and suburbs grow and change. Indeed it could change our entire landscape, and how we live within it, and manage it.

  2. On this one, consider the source. Summers has a vested interest in his message. Buffet on CNBC recently has been highly optimistic about the US economy and the potential for equities. Given the choice I’ll listen to the Sage of Omaha. Put ’em all end to end and you still don’t reach a ….

  3. I should think that Summers scenario would be good for equities, and likely, on balance, for the economy and middle class, particularly.

    • You’re absolutely right. If I bought a 30 year bond in 2005 with a face value of $1,000 paying fixed 5% then whet I really bought was an obligation to pay $50 per year and $1,000 in 2035. If interest rates fall to 2.5% and I want to sell the bond (assuming the risk of the issuer stays constant) I can get $2,000 for the bond. Conversely, if interest rates rose to 10% I’d only be able to sell the bond for $500. In a world where real interest rates (face rate – inflation rate) are near zero the value of newly issued bonds have more downside than upside. So, investors rotate into equities. At least, that’s my understanding. So, a world awash with capital ought to be good for equities since they tend to offer better returns and are in higher demand by investors. A world awash with capital ought to be good for business because businesses can make their internal rates of return by borrowing cheap money. My question concerns the natural correction of this cycle. At some point the disparity between the returns on bonds and the returns on equities gets so wide it’s hard to issue bonds at a rate that investors will buy. So, the bonds have to be issued at higher rates which starts the process of increasing the interest rates and making the world less awash in capital (since capital is getting more expensive). Why isn’t this correction happening? My guess is that governments around the world have been so busy printing money to finance deficits that they are distorting the usual correction process of interest rates. Furthermore, there is enough money in places with high inherent risk (e.g. Saudi Arabia) that the demand for almost risk free government bonds issued by western countries (even at historically low interest rates) remains intact.

      Mr. Summers describes how the world is awash in capital. He then seems to assume that this situation will continue for the foreseeable future. He’s less clear on why the historical cycle of rising and falling interest rates has been broken. His scenario may be right. Investors should consider what they ought to do if the world remains awash in capital. But those same investors should also consider what they will do is the flood of world capital starts to decrease perhaps even rapidly.

      Ulterior motives always have to be considered when listening to a former politico. Summers is arguing for higher taxes, especially at the local ans state level. As Jim notes, pension funds using a 7% rate of return would look a lot less fully funded if they dropped their rate of return to 3% as Summers suggests. While the Federal government can just print the money they need the state and local governments cannot. There are only two answers – cut benefits or raise taxes. Something tells me that Mr Summers would be happier with the latter.

      • Summers’ view also buttresses the liberal critique of the corporate tax cuts, which says that corporations will use most of the money to pay dividends or buy back stock, not invest in expansion. Apple’s action, cited by Summers, is a perfect illustration. So, there is a political aspect to the argument.

        Of course, just because the argument comes from liberals and supports their political critique of Trump economic policy doesn’t mean it’s wrong.

        In find the idea plausible. I also believe, like you, that easy credit policies by central banks also pushes down interest rates. (How can one deny this? They are explicit about their aims!) Perhaps both arguments are true. Interest rates are still cyclical — they’re just fluctuate around a lower equilibrium than they would have been in the past.

        • The logic on the corporate tax rate reductions doesn’t hold water in my book. If a company buys back shares then every share still in the public’s hands represents a slightly bigger ownership stake in the company. Stock prices go up, shareholders sell their shares and pay capital gains and state income taxes on the appreciation. Pay out dividends and the same thing happens.

          I personally think there should be negative consequences for companies which use a large portion of their cash flow to buy back shares or pay out dividends. Perhaps holders of those shares should lose the tax breaks they receive in capital gains rates and qualified dividend rates.

  4. We’ve really been seeing this evolution already with employers using technology to keep from hiring many new workers nor increase wages.

    Workers have for a long time now – not expected to work a career at a company
    nor receive a defined benefit contribution not health care when they retire – that’s now up to Medicare. Even school systems in Virginia will provide retirement health care only until age 65 and it’s then up to Medicare.

    Private sector companies have to be nimble, smart and lucky or else they just disappear or get absorbed by some other company and the employees are on their own… to find the next gig.

    “Investing” in the “future” is a really dicey proposition these days for all but the most strong and resilient companies; technology can totally eradicate thieir basic business model….

    And I totally agree if this is happening… it’s going to radically change a lot of ideas not the least of which is the idea that folks put the money into 401Ks to build retirement income. We already know of a slew of people who at age 65 still do not have enough of a nest egg to retire.

  5. Buffet surely also has a vested interest in his message. He and Summers probably are both right in the context of their objectives and experience.

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